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United States Government Accountability Office:
GAO:
Report to Congressional Committees:
May 2012:
Securities Regulation:
Opportunities Exist to Improve SEC's Oversight of the Financial
Industry Regulatory Authority:
GAO-12-625:
GAO Highlights:
Highlights of GAO-12-625, a report to congressional committees.
Why GAO Did This Study:
SEC oversees FINRA, which is charged with regulatory oversight of all
securities broker-dealers conducting business with the public in the
United States. In light of recent events in the financial markets, SEC
and FINRA have faced questions about their oversight roles. The Dodd-
Frank Wall Street Reform and Consumer Protection Act required GAO to
study SEC’s oversight of national securities associations registered
under section 15A of the Securities Exchange Act of 1934, a provision
which applies only to FINRA. This report examines (1) how SEC has
conducted oversight of FINRA, including FINRA rule proposals and the
effectiveness of its rules, and (2) how SEC plans to enhance its
oversight of FINRA. To address these objectives, GAO reviewed SEC
documentation, policies and procedures for inspections of FINRA and
reviews of FINRA rule proposals; reviewed documentation on SEC’s plans
for enhanced FINRA oversight; and interviewed SEC and FINRA officials.
What GAO Found:
Historically, the Securities and Exchange Commission’s (SEC) oversight
of the Financial Industry Regulatory Authority’s (FINRA) programs and
operations varied, with some programs and operations receiving regular
oversight and others receiving limited or no oversight. Through its
inspection process, SEC conducted routine and special inspections of
various aspects of FINRA regulatory programs, including examinations,
surveillance, and enforcement programs. SEC has also conducted routine
inspections of FINRA’s advertising and arbitration programs but not as
frequently as it had planned. SEC has also regularly reviewed FINRA
proposed rule changes that are subject to SEC approval to determine
consistency with the Securities Exchange Act of 1934 and related rules
and regulations. However, neither SEC nor FINRA conducts retrospective
reviews of FINRA’s rules. GAO and others have reported on the
usefulness of retrospective reviews as they allow agencies to assess
the effectiveness of their rules, and some federal financial
regulators, including SEC, have begun pursuing plans to conduct
retrospective reviews of their rules in light of a recent executive
order that encourages independent regulatory agencies to do so. By not
conducting these reviews, FINRA may be missing an opportunity to
systematically assess whether its rules are achieving their intended
purpose and take appropriate action, such as maintaining rules that
are effective and modifying or repealing rules that are ineffective or
burdensome. Further, by not reviewing what steps FINRA takes in
reviewing its existing rules, SEC may not capture sufficient
information to form an opinion about FINRA’s efforts to review its
rules. Further, SEC has conducted limited or no oversight of other
aspects of FINRA’s operations, such as governance and executive
compensation. According to SEC, these operations were not historically
considered due to competing priorities and resource constraints.
Specifically, SEC officials said that SEC focused its resources on FINRA
’s regulatory departments, which were perceived as programs that have
the greatest impact on investors.
SEC is in the process of enhancing and expanding its oversight of
FINRA using a more risk-based approach. To assess the risks facing
FINRA, SEC has collected a substantial amount of information on FINRA’
s regulatory programs and operations, including for programs and
operations of FINRA for which it has not previously conducted
oversight. SEC has analyzed the information it collected, and,
according to SEC staff, will use this information as it implements its
enhanced risk-based oversight of FINRA later this year. SEC has
followed some elements GAO has previously found to be important in a
risk-management framework, but officials have not articulated or
documented how they will implement all of the elements, such as
considering alternative oversight approaches and monitoring the
effectiveness of its oversight. Incorporating these other elements
will better position SEC to prioritize evolving and varying risks,
evaluate alternatives, and monitor its oversight efforts. Without such
elements, SEC may be missing opportunities to take a more
comprehensive, risk-based approach in overseeing FINRA.
What GAO Recommends:
SEC should encourage FINRA to conduct retrospective reviews of its
rules and establish a process for examining FINRA’s reviews, and SEC
should follow all elements of a risk-management framework in
developing its future oversight plans. SEC generally agreed with GAO’s
recommendations.
View [hyperlink, http://www.gao.gov/products/GAO-12-625]. For more
information, contact A. Nicole Clowers at (202) 512-8678 or
clowersa@gao.gov.
[End of section]
Contents:
Letter:
Background:
The Level of SEC's Oversight of FINRA's Programs and Operations Has
Varied:
SEC's Efforts to Enhance Oversight of FINRA Could Benefit from
Following All Elements of a Risk-Management Framework:
Conclusions:
Recommendations for Executive Action:
Agency Comments:
Appendix I: Scope and Methodology:
Appendix II: Comments from the Securities and Exchange Commission:
Appendix III: GAO Contact and Staff Acknowledgments:
Table:
Table 1: SEC's Oversight of FINRA, 2005 to 2010:
Figure:
Figure 1: Elements of a Risk-Management Framework:
Abbreviations:
COSO: Committee of Sponsoring Organizations of the Treadway Commission:
Dodd-Frank Act: Dodd-Frank Wall Street Reform and Consumer Protection
Act:
Exchange Act: Securities Exchange Act of 1934:
FINRA: Financial Industry Regulatory Authority:
NASD: National Association of Securities Dealers, Inc.
NYSE: New York Stock Exchange:
OCIE: Office of Compliance Inspections and Examinations:
SEC: Securities and Exchange Commission:
SIFMA: Securities Industry and Financial Markets Association:
SRO: self-regulatory organization:
[End of section]
United States Government Accountability Office:
Washington, DC 20548:
May 30, 2012:
The Honorable Timothy Johnson:
Chairman:
The Honorable Richard C. Shelby:
Ranking Member:
Committee on Banking, Housing, and Urban Affairs:
United States Senate:
The Honorable Spencer T. Bachus:
Chairman:
The Honorable Barney Frank:
Ranking Member:
Committee on Financial Services:
House of Representatives:
The securities industry is generally regulated by a combination of
direct Securities and Exchange Commission (SEC) regulation and
industry self-regulation with SEC oversight. Congress adopted self-
regulation, as opposed to direct federal regulation of the securities
markets, to prevent excessive government involvement in market
operations, which could hinder competition and market innovation.
Also, Congress concluded that self-regulation with federal oversight
would be more efficient and less costly to taxpayers. As regulators,
self-regulatory organizations (SRO) such as national securities
exchanges and associations, have responsibility for much of the day-to-
day oversight of the securities markets and broker-dealers under their
jurisdiction. Specifically, SROs are primarily responsible for
establishing the standards under which their members conduct business;
monitoring the way that business is conducted; and bringing
disciplinary actions against their members for violating applicable
federal statutes, SEC’s rules, and their own rules. SEC oversees SROs
to ensure that they are carrying out their regulatory
responsibilities. The Financial Industry Regulatory Authority (FINRA),
an SRO and the only registered national securities association, has
regulatory oversight of all securities broker-dealers doing business
with the public in the United States.[Footnote 1] In particular, FINRA
oversees almost 4,500 brokerage firms and approximately 630,000
registered securities representatives and provides regulatory services
for approximately 80 percent of the trading volume in U.S. equity
markets.
For industry self-regulation to function effectively, SEC must ensure
that SROs are fulfilling their regulatory responsibilities. SEC
oversees FINRA primarily by inspecting its operations and examination
programs and reviewing its proposed rule changes. However, over the
last few years, and specifically in light of recent events in the
financial markets, SEC and FINRA have faced questions about their
oversight roles. These questions include the fairness of FINRA’s
arbitration practices, the rules it crafts related to oversight of
broker-dealers, the limited transparency in its investment practices
and corporate governance, and SEC’s ability to effectively oversee
FINRA.
Section 964 of the Dodd–Frank Wall Street Reform and Consumer
Protection Act (Dodd-Frank Act) requires us to review SEC’s oversight
of national securities associations registered under section 15A of
the Securities Exchange Act of 1934 (Exchange Act), a provision that
solely applies to FINRA.[Footnote 2] Specifically, Section 964
identifies several aspects of SEC’s oversight of FINRA for our review,
including examinations, effectiveness of FINRA’s rules, arbitration
services, advertising regulation, governance, executive compensation,
cooperation with state securities regulators, funding, and policies
regarding former FINRA employees. This report examines (1) how SEC has
conducted oversight of FINRA, including FINRA rule proposals and the
effectiveness of its rules, and (2) how SEC plans to enhance its
oversight of FINRA.
To address these objectives, we reviewed and assessed SEC
documentation, procedures and guidance for inspections of FINRA. To
describe SEC’s oversight of FINRA’s examination programs and selected
services and operations, we evaluated SEC’s planning documentation and
analyzed SEC’s inspection reports from 2005 to 2010 to understand the
details of the reviews and the examination areas targeted by SEC. To
describe how SEC has overseen FINRA rule proposals, we reviewed and
analyzed SEC’s documentation on SRO rulemaking policies and
procedures, including procedures for approving proposed rule changes.
We also interviewed officials from SEC’s Division of Trading and
Markets (Trading and Markets) as well as FINRA to understand what
methods or measures they use to assess the effectiveness of FINRA’s
rules. To determine what steps SEC has taken or plans to take to
enhance its oversight of FINRA, we interviewed officials from SEC’s
Office of Compliance Inspections and Examinations (OCIE) about plans
they have been developing for oversight of FINRA and reviewed OCIE
documentation related to these plans. We also reviewed OCIE’s
preliminary analysis of information collected from FINRA on its
regulatory programs and operations related to areas identified in
Section 964 of the Dodd-Frank Act, and the extent to which OCIE’s
plans to enhance its oversight address these areas. We also
interviewed other stakeholders such as the Securities Industry and
Financial Markets Association (SIFMA) and selected members of SIFMA
who are also members of FINRA, as well as a citizen advocacy group.
Appendix I contains additional information on our scope and methodology.
We conducted our work from August 2011 through May 2012 in accordance
with generally accepted government auditing standards. Those standards
require that we plan and perform the audit to obtain sufficient,
appropriate evidence to provide a reasonable basis for our findings
and conclusions based on our audit objectives. We believe that the
evidence obtained provides a reasonable basis for our findings and
conclusions based on our audit objectives.
Background:
Congress established SEC in 1934 to enforce the Securities Act of 1933
and the Exchange Act. SEC's mission is to protect investors; maintain
fair, orderly, and efficient markets; and facilitate capital formation
by overseeing key participants in the securities markets, including
SROs, securities broker-dealers, investment advisers, and mutual
funds. The agency's functional responsibilities are organized into
five divisions and 18 offices. Of the 18 offices, OCIE is the largest--
with approximately 825 employees--and is responsible for SEC's
nationwide examination and inspection program.[Footnote 3] Individual
groups within OCIE have oversight responsibility for SROs, broker-
dealers, and investment advisers. OCIE's Market Oversight group
examines SROs to ensure that they and their members comply with
applicable federal securities laws and SRO rules. As of April 2012,
there are 33 employees assigned to the Market Oversight group.
Consistent with its oversight responsibilities for other SROs, SEC is
responsible for ensuring that FINRA carries out its regulatory
responsibilities related to oversight of broker-dealers.[Footnote 4]
FINRA's responsibilities include registering and examining all
securities firms doing business with the public, writing rules and
enforcing them, as well as enforcing federal securities laws, and
informing and educating the investing public. One of SEC's principal
oversight mechanisms for FINRA and other SROs is conducting
inspections. Historically, OCIE has conducted both routine and special
inspections of SROs. Routine inspections focused on a particular
program area during each inspection, based on factors such as the
commission's priorities, previously completed inspections, and
enforcement actions. Special inspections arose from a tip or a need to
follow up on past inspection findings and recommendations. Special
inspections have included sweep inspections, whereby OCIE probed
specific activities of all SROs it oversees or a sample of them to
identify emerging compliance issues.
Another principal oversight mechanism for SEC is its authority to
review and, where applicable, approve SRO proposed rules and proposed
changes to existing rules, including those submitted by FINRA.
[Footnote 5] Section 19(b)(2) of the Exchange Act, as amended, and
related rules and regulations, contain the requirements for SRO
proposed rule changes that are subject to SEC approval.[Footnote 6]
These requirements include that an SRO file a proposed rule change
with SEC and publish it on a publicly available website.[Footnote 7]
SEC then sends a notice of the proposed rule change to the Federal
Register and allows interested persons the opportunity to submit
written comments concerning the proposed rule change.[Footnote 8]
Concurrently, SEC reviews the proposed rule change and, if applicable,
considers public comments and the SRO's response. SEC then determines
whether the proposed rule change is consistent with the requirements
of the Exchange Act and Exchange Act rules and regulations that are
applicable to the SRO. SEC has delegated authority to the Trading and
Markets Division to approve proposed rule changes.[Footnote 9] With
the passage of the Dodd-Frank Act, SEC can now directly disapprove
proposed rule changes that are subject to SEC approval if it does not
find that they are consistent with the Exchange Act.[Footnote 10] SEC
also may choose to institute proceedings to determine whether to
disapprove a proposed rule change that is subject to its approval if
it does not approve or disapprove it directly upon its initial review.
[Footnote 11] SEC concludes its review of a proposed rule change by
issuing an approval or a disapproval order.[Footnote 12]
Section 967 of the Dodd-Frank Act directed SEC to engage an
independent consultant to examine its internal operations and
structure and the need for reform. SEC selected the Boston Consulting
Group to conduct the study, and on March 10, 2011, the Boston
Consulting Group issued a report on SEC's organizational and
operational structure. The study focused on four specific areas: (1)
organizational structure, (2) personnel and resources, (3) technology
and resources, and (4) relationships with SROs. The study resulted in
a report of Boston Consulting Group's findings and recommendations,
including some related to SEC's oversight of SROs, and SEC has been
working to implement several of these recommendations. Specifically,
the report recommended that SEC strengthen its oversight of SROs by
developing a set of metrics to assess SRO regulatory effectiveness and
suggested that SEC centralize and coordinate its interactions with
SROs. SEC has established an SRO working group composed of OCIE and
Trading and Markets staff to conduct an evaluation of the current SRO
regulatory structure focusing on two areas: (1) disclosures that SROs
make, both to the public and SEC, regarding their regulatory
operations; and (2) the feasibility of using more defined metrics and
standards to assist SEC's oversight of SROs. OCIE and Trading and
Markets have also jointly developed a communication plan to help
strengthen the oversight of and coordination with SROs and held an
outreach conference in January 2012 with all of the equity and options
exchanges, the Municipal Securities Rulemaking Board, and FINRA to
discuss issues, such as inspection priorities and the SRO rule filing
process.
The Level of SEC's Oversight of FINRA's Programs and Operations Has
Varied:
SEC's oversight of FINRA's programs and operations varied, with some
programs and operations receiving regular oversight and others
receiving limited or no oversight. Through its inspection process,
OCIE conducted routine and special inspections of various aspects of
FINRA regulatory programs, including examinations, surveillance, and
enforcement programs. Similarly, Trading and Markets has regularly
reviewed FINRA's proposed rule changes to determine compliance with
the Exchange Act. However, neither SEC nor FINRA conducts
retrospective reviews of FINRA's rules, which would allow them to
evaluate the effectiveness of these rules. SEC also has conducted
limited to no oversight of other aspects of FINRA's operations, such
as governance and executive compensation. According to OCIE officials,
the limited or no oversight of these FINRA operations were due to
competing priorities and resource constraints. Table 1 summarizes
SEC's oversight of FINRA programs and operations identified in Section
964 of the Dodd-Frank Act, which is the focus of our report.
Table 1: SEC's Oversight of FINRA, 2005 to 2010:
Areas for SEC oversight of FINRA identified in Section 964 of the Dodd-
Frank Act: Examinations and expertise of examiners[C];
Frequency of SEC's reviews:
Annually or continuous[A]: [Check].
Areas for SEC oversight of FINRA identified in Section 964 of the Dodd-
Frank Act: Advertising;
Frequency of SEC's reviews:
Annually or continuous[A]: [Check].
Areas for SEC oversight of FINRA identified in Section 964 of the Dodd-
Frank Act: Rules;
Frequency of SEC's reviews:
Annually or continuous[A]: [Check].
Areas for SEC oversight of FINRA identified in Section 964 of the Dodd-
Frank Act: Arbitration service;
Frequency of SEC's reviews:
Occasionally[B]: [Check].
Areas for SEC oversight of FINRA identified in Section 964 of the Dodd-
Frank Act: Governance;
Frequency of SEC's reviews:
Occasionally[B]: [Check].
Areas for SEC oversight of FINRA identified in Section 964 of the Dodd-
Frank Act: Funding;
Frequency of SEC's reviews:
Occasionally[B]: [Check].
Areas for SEC oversight of FINRA identified in Section 964 of the Dodd-
Frank Act: Post-employment of former employees[D];
Frequency of SEC's reviews:
Occasionally[B]: [Check].
Areas for SEC oversight of FINRA identified in Section 964 of the Dodd-
Frank Act: Executive compensation;
Frequency of SEC's reviews:
Never: [Empty].
Areas for SEC oversight of FINRA identified in Section 964 of the Dodd-
Frank Act: Cooperation with states securities regulators;
Frequency of SEC's reviews:
Never: [Empty].
Areas for SEC oversight of FINRA identified in Section 964 of the Dodd-
Frank Act: Transparency of governance;
Frequency of SEC's reviews:
Never: [Empty].
Source: GAO analysis of SEC documentation.
[A] Annually refers to SEC having conducted oversight of this area or
some aspects of this area on an annual basis. Continuous refers to SEC
reviewing FINRA's rule filings on an ongoing basis.
[B] Occasionally refers to areas for which SEC has not conducted
reviews as regularly as it intended or for which it has only reviewed
some components of the program or operation.
[C] Expertise of examiners is not an area for which SEC has
historically conducted oversight, but related issues such as training
and staffing have been included in its inspections of FINRA.
[D] OCIE formally requested documentation from FINRA related to former
FINRA employees and their new employers prior to conducting
inspections of FINRA district offices. However, OCIE documented its
review of this area in three inspection reports.
[End of table]
OCIE Has Historically Conducted Routine and Special Inspections of
FINRA's Regulatory Programs:
OCIE has historically conducted routine inspections of various aspects
of FINRA's regulatory programs.[Footnote 13] For example, from 2005
through 2010, OCIE conducted 29 inspections of FINRA district offices--
which conduct the majority of broker-dealer examinations--mostly in
accordance with a 3-year cycle that existed during that period.
[Footnote 14] In general, these inspections evaluated various FINRA
district office regulatory programs, as well as FINRA's efforts to
enforce compliance with federal securities laws and FINRA rules.
Specifically, during a district office inspection, OCIE would select
several FINRA regulatory programs for review. The following describes
the type of issues OCIE included in its routine district office
inspections of 3 of FINRA's 16 regulatory programs:[Footnote 15]
* Routine or cycle examinations: In its routine inspections of FINRA's
examination program, OCIE reviewed FINRA's cycle examinations of
broker-dealers to determine whether FINRA district offices met their
goals during the period under review.[Footnote 16] Through its review
of FINRA's examination program, OCIE reviewed district offices'
examination scope, completeness of documentation, and analysis of
member firms' compliance to determine whether FINRA's review was
appropriate.[Footnote 17]
* Financial surveillance system: In its routine inspections of this
program, OCIE reviewed FINRA's financial surveillance and whether the
district office was periodically monitoring member firms' business
activities and financial conditions. In particular, OCIE reviewed
whether the reports generated by the surveillance system were adequate
and whether the district office used the surveillance data to focus
routine examinations on the riskier areas of a firm's business.
* Formal disciplinary action: In its routine inspections of this
program, OCIE reviewed formal disciplinary actions initiated by FINRA
district offices during the period under review. For example, OCIE's
inspection assessed whether FINRA district offices' investigations and
sanctions were appropriate.
While OCIE selected some programs for review more frequently than
others during the period we reviewed (2005-2010), all of FINRA's 16
regulatory programs were reviewed at least once across the 29 district
office inspections. We earlier reported that, according to OCIE
officials, OCIE tailored inspections in the past to focus on those
areas judged to pose the greatest risk to the SRO or the general
market, considering such factors as the amount of time that passed
since a particular area was last inspected and the results of past
inspections.[Footnote 18] In these inspections, OCIE identified some
deficiencies related to FINRA's broker-dealer examinations, such as
inadequate documentation, insufficient sampling, and the timeliness of
reviews. However, OCIE generally found that FINRA's district offices
conducted thorough reviews of their member firms and that district
offices generally addressed deficiencies from the prior inspection.
In addition to the district office inspections, OCIE conducted routine
inspections of FINRA's oversight related to advertising. However,
these inspections occurred less frequently than what was stated in
OCIE's planned inspection timelines.[Footnote 19] In particular, while
OCIE's then existing timelines called for inspections once every 4
years, OCIE conducted inspections of FINRA's advertising regulatory
program in 1998 and 2005. According to OCIE, the timelines were not
followed due to resource constraints and competing priorities. In the
1998 and 2005 inspections, OCIE reviewed FINRA's assessment of
communications submitted by member firms to evaluate their compliance
with FINRA advertising rules as well as FINRA's investigation of
alleged violations of these rules.[Footnote 20] In the advertising-
related submissions and investigation files reviewed by OCIE in 1998
and 2005, OCIE generally found that FINRA's review met the
requirements of FINRA rules, and the OCIE review team did not identify
substantial issues with FINRA's oversight of member firms. Although
OCIE did not meet their proposed timelines for conducting routine
inspections of FINRA's advertising program, our analysis of OCIE's
inspections showed that OCIE also reviewed advertising through other
efforts, such as including it in some of the FINRA district office
inspections previously discussed. Specifically, OCIE reviewed
advertising in at least one FINRA district office each year between
2005 and 2010. In those inspections, OCIE reviewed whether the
district offices took steps to ensure that customer communications
were appropriately reviewed and approved.
OCIE also conducted routine inspections of FINRA's arbitration
program. According to OCIE guidance, OCIE planned to conduct
inspections of FINRA's arbitration program on a 2-year cycle, but it
did not follow this planned schedule. OCIE conducted inspections of
FINRA's arbitration program in 2000, 2005, and 2010. The 2000
arbitration program inspection evaluated how FINRA administers various
aspects of the arbitration program including evaluation of the
arbitrators, training, and processing of cases, and OCIE found that
FINRA generally processed cases in accordance with its guidance. The
2005 inspection, which inspected the New York Stock Exchange's (NYSE)
arbitration program that later consolidated into FINRA's arbitration
program, identified some deficiencies related to incorrect
classifications of some arbitrators, and a lack of sufficient
documentation in response to a complaint or negative evaluation
regarding an arbitrator. However, OCIE staff found that NYSE either
had taken or was taking steps to address these deficiencies. The 2010
inspection of FINRA's arbitration program focused on a sample of FINRA
arbitrators, and OCIE's report found that FINRA generally followed its
internal procedures related to the qualifications and classifications
of its pool of arbitrators. The report also found that FINRA generally
removed arbitrators from its roster due to inappropriate conduct or if
the arbitrator received credible poor evaluations on a consistent
basis.
OCIE has also conducted special inspections--which can arise from tips
or the need to follow up on prior recommendations or enforcement
actions--of FINRA regulatory programs, as warranted. For example, OCIE
inspected FINRA's fixed-income regulatory program in 2006 and was in
the process of completing a report for another inspection of this
program as of May 2012.[Footnote 21] Further, due to market
conditions, the events of May 6, 2010, also known as the "flash
crash," and the dynamic nature of the secondary markets, OCIE has
initiated a review of FINRA's surveillance of high-frequency trading.
[Footnote 22] For this inspection, OCIE examiners plan to evaluate the
effectiveness of FINRA's automated surveillance programs to detect
trading abuses related to high-frequency trading and algorithmic
trading. OCIE officials explained that competing priorities have
prevented them from conducting these types of special inspections of
SROs on a more frequent basis. Additionally, OCIE conducted other
inspections of FINRA (and its predecessor NASD) from 2005 through 2010
that examined other FINRA programs and operations, such as FINRA's
anti-money-laundering review program, front-end cause unit, and
internal audit department.
Neither SEC nor FINRA Has a Formal Process for Evaluating the
Effectiveness of Implemented FINRA Rules:
SEC's Division of Trading and Markets regularly reviews FINRA's rule
filings and has a formal process in place for its reviews and
decisions related to filings. Trading and Markets reviews FINRA
proposed rule changes that are subject to SEC approval to determine
whether they are consistent with the Exchange Act, and related rules
and regulations. During its review, Trading and Markets determines
whether a proposed rule change complies with all of the requirements
of Form 19b-4--a form that instructs SROs, including FINRA, to provide
required information, presented in a clear and comprehensible manner
to enable the public to provide meaningful comment and for SEC to
determine whether a proposed rule change is consistent with the
Exchange Act.[Footnote 23] If a proposed rule change does not comply
with the form requirements, Trading and Markets rejects the filing. If
FINRA re-files the proposed rule change and it is complete, Trading
and Markets publishes it for public comment.[Footnote 24] Trading and
Markets then determines whether the proposed rule change is consistent
with the Exchange Act and, if subject to SEC approval, approves or
disapproves it.[Footnote 25] From 2009 through 2011, SEC issued more
than 400 releases regarding FINRA proposed rule changes.[Footnote 26]
We reviewed a sample of 19 of these releases and found that SEC
consistently provided reasons for approving or disapproving proposed
rule changes.[Footnote 27]
Trading and Markets has taken steps to strengthen its review of FINRA
proposed rule changes based on recommendations in the Boston
Consulting Group study. First, in implementing recommendations from
the study, Trading and Markets has developed a more formal structure
to consult with OCIE, which has expertise in reviewing and assessing
an SRO's regulatory plan and practices. Trading and Markets officials
explained that they previously consulted with OCIE on proposed rule
changes when necessary but had done so on an informal basis. Second,
SEC has also developed an action plan to address other Boston
Consulting Group report recommendations, such as plans to provide
additional guidance in order to strengthen and clarify the SRO rule
filing process. Third, Trading and Markets officials stated that they
are formally tracking complex proposed rule changes under review
because Section 916 of the Dodd-Frank Act modified certain procedures
under Section 19(b) of the Exchange Act, setting tighter time frames
for approving proposed rule changes and imposing stricter consequences
if deadlines are not met. For example, under Section 916, if SEC does
not send a notice to the Federal Register within 15 days of when FINRA
posts the proposed rule change on its website, the publication date
defaults to the date of FINRA's website posting, which shortens the
review period.[Footnote 28] Prior to the Dodd-Frank Act, Trading and
Markets officials stated that they tracked complex proposed rule
changes for the Commission on an informal basis. Finally, Trading and
Markets assisted in organizing SEC's SRO outreach conference in
January 2012 to provide information on, and promote transparency of,
the SRO rule filing process.[Footnote 29]
While SEC reviews FINRA proposed rule changes, it does not have a
formal process for conducting retrospective reviews of FINRA rules.
Retrospective reviews assess the effectiveness of FINRA rules after
they have been implemented. Trading and Markets officials told us that
through the process of soliciting comments and conducting reviews of
proposed rule changes, SEC gathers information on the potential
effects that they may have on the industry. Moreover, according to
officials, OCIE may look at a particular rule after approval through
targeted or broad examinations of FINRA's operations and services if
industry participants or others have raised concerns. For example,
OCIE officials stated that in one case, they found that fragmentation
in the trading of NASDAQ securities was hindering the ability of the
National Association of Securities Dealers, Inc. (NASD)--FINRA's
predecessor--to create a complete audit trail and recommended that
NASD amend a rule regarding its Order Audit Trail System and require
member firms to report complete order information to NASD. However,
SEC does not have specific guidance or protocols for conducting
retrospective reviews of FINRA's implemented rules.
FINRA also does not have a formal process for conducting retrospective
reviews of its rules, but it may review implemented rules informally,
according to FINRA officials. FINRA officials stated that there are
several mechanisms that they employ in their routine oversight
activities that could be used to evaluate the effectiveness of
implemented rules. These mechanisms include soliciting feedback from
FINRA's Board of Governors and industry organizations, analyzing
customer complaints and arbitration claims, and performing examination
and oversight functions related to member and market regulation. FINRA
officials also stated that they review existing rules when there are
new industry developments. Further, FINRA officials stated that the
ongoing consolidation between the NASD and NYSE rulebooks--which was
part of FINRA's creation in 2007--provides an opportunity to evaluate
the effectiveness of existing FINRA rules. However, without a more
formal process in place to examine its implemented rules, FINRA might
miss opportunities to consistently evaluate the effectiveness of its
rules. Further, SEC currently does not have a process by which it
reviews what steps FINRA takes in reviewing its existing rules, which
could result in SEC not capturing sufficient information to form an
opinion about FINRA's efforts to review its rules. OCIE staff is
currently reviewing how FINRA's regulatory programs evaluate the
effectiveness of FINRA's rules and how FINRA's rulemaking process
helps to ensure the effectiveness of its rules.
Recently, federal financial regulators have been encouraged to conduct
retrospective reviews of existing rules. In 2011, the President signed
Executive Order 13579, which asked independent regulatory agencies,
such as SEC, to develop plans for reviewing existing significant
regulations.[Footnote 30] The order encourages these agencies to
conduct retrospective reviews of their rules in order to modify or
repeal rules that may be ineffective, insufficient, or excessively
burdensome. We and others have also reported on the usefulness of
retrospective reviews of rules, including their ability to inform
policymakers about the design of rules and regulatory programs.
[Footnote 31] Although the financial regulators are not required to
follow Executive Order 13579, SEC is developing plans for conducting
retrospective reviews of its rulemaking. Specifically, SEC has issued
a Federal Register notice soliciting public comments to assist the
agency in developing plans for conducting retrospective reviews in
response to the executive order.[Footnote 32]
While Executive Order 13579 does not apply to FINRA, its regulatory
responsibilities are similar to those of federal financial regulators.
[Footnote 33] Specifically, FINRA proposes many rules and rule changes
each year in its regulatory role of overseeing broker-dealers and the
markets in which they operate. These rules can have an impact similar
to those proposed and implemented by financial regulators, such as
SEC. Thus, the Executive Order could provide SEC criteria to encourage
FINRA to conduct retrospective reviews of its rules. By not conducting
retrospective reviews of its rules, FINRA may be missing an
opportunity to assess whether its rules are achieving their intended
purpose.
OCIE Has Conducted Limited or No Oversight of Other Aspects of FINRA's
Operations:
OCIE has conducted limited oversight of some aspects of FINRA's
operations, as described below.
* Governance: SEC has not directly overseen FINRA's governance but has
monitored structural changes of the Board of Governors to ensure that
policies and rules related to governance are being appropriately
followed. For example, SEC and FINRA officials told us that OCIE has
periodically reviewed the composition of FINRA's board to determine
compliance with SRO board-composition requirements.[Footnote 34]
Through its authority to review FINRA rule filings, Trading and
Markets also reviews new rules or proposed changes to existing rules
related to corporate governance or other governance-related issues.
However, SEC has not historically examined issues such as conflicts of
interest or recusals related to FINRA's governance.
* Funding: Although OCIE has not examined the sufficiency of FINRA's
funding in the past, OCIE officials told us that they have reviewed
FINRA's annual report and any relevant information to understand
FINRA's finances. For example, OCIE has reviewed this information to
determine whether FINRA needs more resources in certain areas, such as
training. OCIE officials have not historically focused on the adequacy
of FINRA's funding because of competing priorities and resource
constraints.
* Employment of former FINRA employees at regulated entities: OCIE's
guidelines for inspections of FINRA district offices included
information about examining FINRA examiners who had terminated their
employment. In addition, according to OCIE officials, inspections of
district offices typically include a review of issues related to
former FINRA employees. For example, from 2005 through 2010, OCIE
formally requested documentation from FINRA related to former FINRA
employees and their new employers prior to conducting inspections of
FINRA district offices. OCIE officials provided three inspection
reports that documented that this issue was examined in the
inspections during this period.
OCIE has not historically conducted oversight of some areas of FINRA's
programs and operations identified in Section 964, including FINRA's
executive compensation, cooperation with state securities regulators,
and transparency of FINRA's governance. Specifically, OCIE officials
told us that they focused their limited resources on FINRA's
regulatory departments which they perceived as programs that have the
greatest impact on investors. However, as will be discussed, SEC is
currently re-evaluating its oversight of FINRA, including the levels
of oversight dedicated to aspects of FINRA's programs and operations
that it has not historically overseen.
SEC's Efforts to Enhance Oversight of FINRA Could Benefit from
Following All Elements of a Risk-Management Framework:
OCIE is in the process of enhancing and expanding its oversight of
FINRA using a more risk-based approach. In 2010, OCIE transitioned
from conducting routine, or cycle-based, inspections of the SROs it
oversees, including FINRA, to a more risk-based approach to oversight.
We have previously reported that, according to OCIE officials, in the
past OCIE tailored inspections to focus on areas with the greatest
risks and considered the results of past inspections and other factors
in planning routine inspections.[Footnote 35] However, OCIE continued
to conduct inspections on a cycle-basis. With the transition to a more
risk-based inspection process, OCIE officials stated that they are
working to focus their resources on the most critical and high-risk
areas in their oversight of FINRA and other SROs, rather than
continuing to conduct cycle-based inspections. To assess the risks
facing FINRA and conduct reviews of FINRA programs, OCIE collected a
substantial amount of information on FINRA's regulatory programs and
operations, including those for which it had not previously conducted
oversight but which Section 964 of the Dodd-Frank Act identified. OCIE
has analyzed the information it collected, and, according to OCIE
officials, will use this information as it implements its enhanced
risk-based oversight of FINRA later in 2012. While OCIE has followed
some elements of a risk-management framework as it has considered its
existing and future oversight of FINRA, it has not addressed all
elements of the framework. For example, OCIE officials have not
articulated or documented how they will select the appropriate
alternatives for enhanced oversight and how they will monitor the
implementation of OCIE's oversight. Without doing so, OCIE may be
missing opportunities to take a more comprehensive approach to
considering all risks and alternatives associated with oversight of
FINRA, as well as the monitoring of its future efforts.
OCIE Is Assessing FINRA's Risks as Part of Its Efforts to Enhance and
Expand Oversight of FINRA:
With the goal of enhancing its oversight of FINRA, OCIE is working to
assess potential risks FINRA faces. These risks may also affect SEC's
general oversight of the securities industry, and more specifically,
how SEC will oversee FINRA. To assess potential risks FINRA faces,
OCIE has obtained information and data on various aspects of FINRA's
regulatory programs and operations. This includes information on
FINRA's examinations of broker-dealers, its surveillance programs,
arbitration, advertising regulation, and governance. It also has
collected information from FINRA's internal audit reports, and reports
prepared by third parties for FINRA.[Footnote 36] OCIE officials said
that they focused their information collection efforts on the areas
identified in Section 964 of the Dodd-Frank Act because these were the
risks that Congress identified.
OCIE officials have analyzed the information they collected for
different FINRA programs and operations, including areas that they
have previously overseen.
* Examinations. According to OCIE's preliminary analysis of the
information collected, OCIE has analyzed the number of examinations
FINRA has conducted of member firms as well as the number of examiners
that FINRA employed between 2008 and 2010. OCIE has also been
reviewing several aspects of FINRA's examination programs to further
develop its risk-based approach, including how FINRA communicates with
its members and SEC about its examination programs. For example,
according to OCIE's analysis, OCIE staff are reviewing the extent to
which FINRA's examination process is transparent to its member firms
and SEC. OCIE staff are also reviewing how FINRA is filling open
examiner positions with well-qualified applicants, and how FINRA
trains its examiners. To assess how FINRA has filled examiner
positions with well-qualified applicants, OCIE obtained data on
recently hired staff in FINRA's examination program, staff turnover
rates, criteria that FINRA uses in determining experience levels of
its staff, and guidelines on how FINRA staffs examinations. OCIE also
obtained information, such as job descriptions, that outlines
education and experience requirements for examiner positions.
According to OCIE officials, this information will be used to develop
a systematic review of examiner expertise in future inspections of
FINRA. OCIE officials are also reviewing how FINRA compensates and
trains its examiners, including whether FINRA assesses the adequacy of
examiner compensation.
* Arbitration. According to OCIE's analysis, OCIE staff are reviewing
FINRA's documentation and procedures related to arbitrator selection.
In addition, OCIE staff are examining staffing levels, staffing
changes, and staff compensation in FINRA's dispute resolution
department and FINRA's procedures for monitoring trends in case
filings. OCIE staff are also reviewing information regarding FINRA's
procedures for establishing performance benchmarks for its arbitration
program, such as the time to serve claims and appoint arbitrators.
* Advertising. OCIE staff are reviewing FINRA's funding of its
advertising regulation department to determine whether it is receiving
adequate funding to sufficiently implement, administer, and staff
FINRA's advertising review program. OCIE staff have conducted
preliminary analysis on how many member filings each analyst in
FINRA's advertising regulation department is expected to review, the
turn-around time for filings, the number of filings submitted relative
to the number of staff reviewing them, and supervisory reviews of
analysts' work. According to OCIE officials, this analysis is designed
to inform future, risk-based inspections of FINRA's advertising
program and target areas that warrant the most attention.
OCIE also collected information on aspects of FINRA's operations for
which OCIE has historically conducted limited or no oversight but
which Section 964 of the Dodd-Frank Act identifies. These aspects
include oversight related to FINRA's governance, cooperation with
state securities regulators, policies regarding former FINRA
employees, executive compensation, and funding.
* Governance. According to OCIE's analysis, OCIE staff are reviewing
information board members receive from FINRA management in carrying
out their duties and the extent to which governance practices are
transparent. OCIE staff are examining the process by which FINRA
governors recuse themselves from matters that raise a potential
conflict of interest. According to OCIE staff, they are also examining
other governance-related issues, such as independence and fiduciary
duties and the expertise and skill sets of FINRA governors.[Footnote
37]
* Cooperation with state securities regulators. OCIE staff have been
reviewing the extent to which FINRA communicates effectively with
state securities regulators. OCIE staff are also exploring whether any
opportunities exist for improving cooperation between FINRA and state
securities regulators, as OCIE recognizes the importance of enhanced
communication between FINRA and state securities regulators. Such
communication could become even more important if FINRA becomes an SRO
for investment advisers. Although there are many variations of what an
investment advisor SRO could look like, one scenario is that FINRA
could share examination authority over certain investment advisers
with state regulators alone rather than with state regulators and SEC,
as is currently the case with broker-dealers.
* Post-employment policies regarding former FINRA employees. OCIE
staff have been reviewing FINRA's written procedures concerning former
employees and comparing FINRA and SEC post-employment restrictions to
assess whether FINRA could implement additional controls. OCIE staff
are also examining policies that FINRA has adopted and take effect in
July 2012 that place restrictions on former FINRA officers, such as
vice presidents, senior vice presidents, and higher-ranking FINRA
executives. These restrictions would prevent a former FINRA officer
from appearing in a FINRA disciplinary proceeding for 1 year following
the date of that officer's separation from FINRA.
* Executive compensation. OCIE has obtained information and data on
FINRA executive compensation, including retirement plans and incentive
compensation for its executives. OCIE staff have been reviewing the
data, specifically focusing on compensation FINRA pays its senior
executives and the annual goals set by FINRA's Management Compensation
Committee. These goals include those that FINRA senior executives must
meet to qualify for incentive compensation and the analysis and
deliberations undertaken by FINRA, the Management Compensation
Committee, and FINRA's Board of Governors in connection with the award
of incentive compensation. According to OCIE's analysis, OCIE
officials are also reviewing the firms or entities that FINRA uses for
compensation benchmarking purposes and examining studies conducted by
FINRA's compensation consultant.[Footnote 38] We reviewed the three
most recently completed compensation studies conducted by the
consultant--in 2009, 2010, and 2011--and found that these studies
concluded that FINRA's pay levels are appropriate relative to certain
comparable regulators, exchanges, and financial services organizations
engaged in brokerage or related banking.
* Funding. As part of its analysis, OCIE officials are examining
FINRA's annual budget process among other funding-related items. In
particular, officials observed budget discussions and interactions
during FINRA's annual planning process between FINRA's operating
departments and divisions, FINRA's Financial Planning and Initiatives
team (which develops FINRA's budget), senior management, the Finance
and Operations Committee, and the Board of Governors. Further,
officials are reviewing FINRA's Board of Governors' oversight of the
budgeting process. OCIE officials have also been assessing issues
concerning FINRA's investment portfolio, such as FINRA decisions
related to levels of portfolio contributions to annual spending. In
addition, OCIE officials are reviewing FINRA's management of
investment-related conflicts of interest. Finally, as part of its
monitoring of FINRA's resource allocation, OCIE officials are
assessing FINRA's plans to fund an investment adviser oversight
program and how FINRA would maintain sufficient funding to fulfill its
current core regulatory programs relating to broker-dealers. FINRA has
indicated an interest in becoming an SRO for investment advisers if
Congress were to approve legislation permitting the creation of one or
more SROs for investment advisers.
OCIE's analysis of the information collected on FINRA's programs and
operations is ongoing. OCIE officials anticipate using the information
they have collected and analyzed to inform their planning of future
oversight of FINRA. According to OCIE officials, implementation of
OCIE's enhanced, risk-based FINRA oversight will begin later in the
year.
OCIE's Methodology for Developing Enhanced, Risk-Based Oversight of
FINRA Could Benefit From More Closely Following a Risk-Management
Framework:
While OCIE is engaged in efforts to develop and implement an enhanced
risk-based approach to oversight of FINRA, its approach does not
follow all the elements of a formal risk-management framework.
According to OCIE staff, they developed the framework for their risk-
based approach, in part, by considering the Committee of Sponsoring
Organizations of the Treadway Commission's (COSO) enterprise
management framework.[Footnote 39] COSO's enterprise risk-management
framework contains eight components for managing risk: internal
environment, objective setting, event identification, risk assessment,
risk response, control activities, information and communication, and
monitoring. However, OCIE officials explained that they modified this
framework to focus on three elements: (1) risks facing FINRA, (2)
internal controls FINRA has in place to mitigate those risks, and (3)
the residual risks that are not mitigated by the existing internal
controls. OCIE officials explained that they decided to modify the
COSO framework, in part, to customize the process to OCIE's needs and
expertise.
In prior work, we have reported on the benefits of risk management and
identified elements of a risk-management framework for federal agency
oversight efforts.[Footnote 40] Risk management provides the rigor and
structure necessary to enable entities, on a continuous basis, to
enhance their capability to identify potential adverse events, assess
risks, and establish appropriate responses. Figure 1 shows the five
elements for a risk-management framework, which are also described
below. All of these are critical to OCIE's efforts to develop an
enhanced risk-based inspection program.
* Identify strategic goals, objectives, and constraints refers to
identifying the strategic goals that are trying to be achieved and the
steps needed to attain those goals. It also includes determining
limitations or constraints that affect the desired outcomes.
* Risk assessment refers to identifying the key aspects of potential
risk.
* Alternatives evaluation refers to considering measures to reduce the
identified risks.
* Management selection refers to management selecting where resources
and investments will be made based on selecting the appropriate
alternatives for reducing risks.
* Implementation and monitoring refers to how the steps to reduce risk
will be applied and monitored to help ensure ongoing effectiveness.
Figure 1: Elements of a Risk-Management Framework:
[Refer to PDF for image: illustration]
Interlocking circular segments:
Strategic Goals, Objectives, and Constraints:
Risk Assessment:
Alternatives Evaluation:
Management Selection:
Implementation and Monitoring:
Source: GAO.
[End of figure]
While these elements are designed for agencies overseeing their own
risks and programs, they can be applied to SEC's oversight of FINRA
and its efforts to enhance its oversight. To oversee the securities
markets, SEC leverages its own capabilities as well as those of the
SROs it oversees, including FINRA. For example, SEC relies on FINRA
for examinations of broker-dealers and in instances where SEC and
FINRA pursue joint enforcement actions. As such, the risks associated
with FINRA's surveillance programs and its oversight of broker-dealers
potentially affect SEC's ability to effectively regulate the
securities markets. Specifically, FINRA's regulation of its members
and its surveillance activities serve as crucial oversight functions,
on which SEC relies. A failure of FINRA's oversight is a risk to SEC
and its ability to fulfill its mission. Therefore, for SEC to conduct
effective oversight of the securities markets, it must take steps to
ensure that FINRA is performing these functions properly.
OCIE has taken steps to incorporate the first two elements of the risk-
management framework. OCIE has identified its goals and objectives--
specifically, enhancing oversight of FINRA--and is assessing FINRA's
potential risks. As previously mentioned, OCIE plans to develop an
oversight plan based on its risk assessments and will focus on the
risk areas determined to be the highest risk. To inform its oversight
plan, OCIE plans to conduct risk assessments on a regular basis. For
example, OCIE has already imbedded procedures for identifying risks
related to FINRA's regulatory programs in its district office
inspection procedures.
However, while OCIE officials have addressed two of the five elements,
they have not articulated or documented how they plan to implement the
remaining three elements of the risk-management framework: considering
alternatives for reducing risks; selecting the appropriate
alternatives for enhanced oversight; and implementing and monitoring
its risk-based oversight. While OCIE officials may have initiated
internal discussions about these elements, they have not formally
presented specific steps for them, nor are all three elements apparent
in the modified risk-management approach OCIE adopted. Because these
elements are not formally articulated, OCIE may not be in the best
position to determine whether its staff are actively considering how
to implement and monitor enhanced oversight of FINRA once the key
risks are identified and prioritized.
The remaining three elements of the risk-management framework could
also provide SEC with other opportunities to improve its oversight
efforts. For example, the areas identified in Section 964 of the Dodd-
Frank Act may not contain an equal amount of risk, and that risk may
vary over time. As such, SEC must continuously identify and prioritize
these evolving risks in order to appropriately target its resources.
Further, the FINRA programs and operations identified in Section 964
may not encompass all current and future risks. For example, should
FINRA become the SRO for investment advisers, SEC would need to
consider the potential impact of FINRA's additional responsibilities
and reassess risks related to FINRA's current oversight of broker-
dealers and its surveillance functions. Moreover, as we have
previously recommended, leveraging the findings in FINRA's internal
audits is another important source of information that SEC could use
to assess current or evolving risks.[Footnote 41] Establishing all
elements of a risk-management framework would provide SEC with a
comprehensive plan to develop the appropriate options to identify
current and future risks, including those not specifically identified
in Section 964 of the Dodd-Frank Act, prioritize them, and implement
an oversight plan that can be monitored for effectiveness. Without
such elements, OCIE may be missing opportunities to take a more
comprehensive approach to considering all risks and alternatives
associated with oversight of FINRA, as well as the monitoring of its
future efforts.
Conclusions:
SEC has a formal process for reviewing FINRA's proposed rule changes
and has recently taken steps to strengthen its review process.
However, neither FINRA nor SEC has a formal process for evaluating the
effectiveness of FINRA's implemented rules. Increasing attention has
recently been given to the importance of these retrospective reviews
and some federal financial regulators, including SEC, have begun
pursuing plans to conduct retrospective reviews of their rules.
Although FINRA also publishes rules governing the securities markets,
it is not required to conduct such reviews of its rules. However,
given its role in regulation, FINRA proposes many rules and rule
changes each year that can have an impact similar to rules proposed
and implemented by SEC. By not conducting retrospective reviews, FINRA
may be missing an opportunity to systematically assess whether its
rules are achieving their intended purpose and take appropriate
action, such as maintaining rules that are effective and modifying or
repealing rules that are ineffective or burdensome.
SEC is in the process of enhancing and expanding its oversight of
FINRA, using a more risk-based approach. To inform these plans, SEC
has worked to assess the risks associated with the FINRA programs and
operations. Moving forward, incorporating the other elements we have
previously identified for a comprehensive risk-management framework
will be important, including prioritizing risks and monitoring the
effectiveness of its oversight. For example, although SEC collected
information on all FINRA programs and operations identified in Section
964 of the Dodd-Frank Act, the risks posed by the individual programs
and operations could vary and therefore warrant different levels of
oversight. Moreover, the FINRA programs and operations identified in
Section 964 may not encompass all current and future risks, such as
FINRA becoming an SRO for investment advisers. Incorporating these
other elements of the risk management framework will better position
SEC to identify and prioritize evolving risks, evaluate alternatives
and monitor its oversight efforts. Without such elements, SEC may be
missing opportunities to take a more comprehensive, risk-based
approach in overseeing FINRA.
Recommendations for Executive Action:
As SEC works to enhance its oversight of FINRA, we recommend that the
SEC Chairman take the following two actions:
* encourage FINRA to conduct retrospective reviews of its rules and
establish a process for examining FINRA's reviews; and:
* direct OCIE to follow all elements of a risk-management framework as
it develops plans for an enhanced risk-based approach to FINRA
oversight, such as developing plans for how it will prioritize risks
related to oversight of FINRA and assessing the effectiveness of its
risk-based model.
Agency Comments:
We provided a draft of this report to SEC for review and comment. In
its comment letter, which is reprinted in appendix II, SEC generally
agreed with our recommendations. Pursuant to our first recommendation
concerning retrospective reviews of rules, the SEC Chairman has
requested that OCIE and Trading and Markets encourage FINRA to
consider additional methods to conduct these reviews. The Chairman has
also requested that OCIE consider the most effective method to examine
or monitor FINRA's reviews of its rules. In response to our second
recommendation that OCIE follow all elements of a risk-management
framework, SEC commented that they had planned to do so and agreed
that implementation of the remaining elements of a risk-management
framework may better position OCIE to take a more comprehensive, risk-
based approach in overseeing FINRA. As such, OCIE will consider how
best to prioritize evolving and varying risks, evaluate alternatives,
and monitor oversight efforts related to its oversight of FINRA. SEC
also provided technical comments on the draft report, which we
incorporated as appropriate.
We also provided portions of the draft report to FINRA for review and
comment. FINRA provided technical comments, which we incorporated as
appropriate.
We are sending copies of this report to the Chairman of the Securities
and Exchange Commission, the appropriate congressional committees, and
other interested parties. In addition, the report will be available at
no charge on GAO's website at [hyperlink, http://www.gao.gov].
If you or your staffs have any questions about this report, please
contact me at (202) 512-8678 or clowersa@gao.gov. Contact points for
our Offices of Congressional Relations and Public Affairs may be found
on the last page of this report. GAO staff who made major
contributions to this report are listed in appendix II.
Signed by:
A. Nicole Clowers:
Director, Financial Markets and Community Investment:
[End of section]
Appendix I: Scope and Methodology:
The objectives of this report were to examine (1) how the Securities
and Exchange Commission (SEC) has conducted oversight of the Financial
Industry Regulatory Authority (FINRA), including FINRA rule proposals
and the effectiveness of its rules, and (2) how SEC plans to enhance
its oversight of FINRA.
To address our first objective, we reviewed and assessed SEC
documentation, procedures, and guidance for inspections of FINRA. To
describe how SEC has conducted oversight of FINRA's examination
programs specifically, we reviewed and assessed SEC's Office of
Compliance Inspections and Examinations' (OCIE) procedures and
guidance for inspections of FINRA's examination programs, including
OCIE's guidelines for oversight inspections of FINRA district offices,
inspection planning memorandums, and advertising inspection
checklists. We analyzed all (29) of OCIE's inspection reports of FINRA
district offices for inspections conducted from 2005 to 2010 to
understand the details of the reviews, including the scope and
findings of the inspections. Additionally, we reviewed other OCIE
inspection reports related to aspects of FINRA oversight identified in
Section 964 of the Dodd-Frank Wall Street Reform and Consumer
Protection Act of 2010 (Dodd-Frank Act), including the 1998 and 2006
inspections of the National Association of Securities Dealers, Inc.'s
(NASD) Department of Advertising Regulation, 2000 inspection of NASD
Dispute Resolution's Midwest Regional Office, 2002 inspection of
NASD's surveillance program for member-firm trading in municipal
securities, and 2006 inspection of NASD's regulatory program for fixed-
income securities. We also reviewed relevant documentation OCIE
collected from FINRA, including FINRA's member regulation handbook,
samples of letters FINRA sends to firms to discuss various regulatory
issues, and questionnaires FINRA uses in its meetings with member
firms when conducting oversight examinations. We reviewed request
letters SEC submitted to FINRA for inspections that SEC had recently
initiated of FINRA's surveillance programs related to fixed income and
high-frequency trading. We also interviewed SEC, FINRA, and North
American Securities Administrators Association officials. Moreover, we
interviewed other relevant stakeholders such as the Securities
Industry and Financial Markets Association (SIFMA), members of SIFMA
who are also members of FINRA, and a citizen advocacy group. SIFMA
assisted us in identifying members who varied in size--small, medium
and large--and had been in existence prior to the creation of FINRA in
2007. We also reviewed relevant prior GAO reports regarding SEC
oversight of FINRA and self-regulatory organizations (SRO) in general.
To describe how SEC has overseen FINRA's proposed rule changes and
what methods or measures SEC and FINRA use to assess the effectiveness
of FINRA's implemented rules, we reviewed and analyzed SEC's
documentation on SRO filing policies and procedures, including SEC
procedures for approving proposed rule changes, relevant federal
statutes governing SEC's review of SRO rule filings, and recent
executive orders regarding retrospective reviews of existing
regulations. We also interviewed officials from SEC's Division of
Trading and Markets, FINRA, members of SIFMA who are also members of
FINRA, and we reviewed prior GAO reports on agencies conducting
retrospective reviews of existing rules.
To understand the steps SEC takes to review and approve or disapprove
FINRA's proposed rule changes, we analyzed a random sample of SEC
releases regarding FINRA's proposed rule changes issued in 2009, 2010,
and 2011.[Footnote 42] We selected the years 2009 through 2011 because
these were the most recent years that contained a full year of
releases and included a full year of releases before and after the
enactment of the Dodd-Frank Act. We examined SEC releases approving
proposed rule changes, granting accelerated approval of proposed rule
changes, notifying the public of immediately effective proposed rule
changes, and disapproving proposed rule changes.
1. Approved: Proposed rule changes from SROs, including FINRA, that
were filed for approval under section 19(b)(2) with approval occurring
after the 30th day of the publication date (date of the Federal
Register publication or SRO website posting).
2. Accelerated approval: Amendments to previously filed proposed rule
changes from SROs, including FINRA, that were filed for approval under
section 19(b)(2) with approval occurring before the thirtieth day of
the publication date (date of the Federal Register publication or SRO
website posting).
3. Immediately effective: Certain categories of proposed rule changes
from SROs, including FINRA, that were filed for immediate
effectiveness under section 19(b)(3)(A). Categories include (i) rules
constituting a stated policy, practice, or interpretation with respect
to the meaning, administration, or enforcement of an existing rule,
(ii) rules establishing or changing a due, fee, or other charge
imposed by the self-regulatory organization on any person, or (iii)
rules concerned solely with the administration of the self-regulatory
organization or other matters specified by SEC.
4. Disapproved: Proposed rule changes from SROs, including FINRA, that
were filed for approval under Section 19(b), but were disapproved.
We obtained a list of all SEC releases regarding FINRA proposed rule
changes from SEC's website for the years 2009 through 2011, a total of
432 releases. We identified all approved, accelerated approval,
immediately effective, and disapproved release types issued during the
3 years and randomly selected two occurrences for each type of release
for each year. There was only one occurrence of a disapproved release
available on SEC's website for the time period of 2009 through
2011.The result was a nongeneralizable sample of 19 SEC releases (18
approved, accelerated approval, and immediately effective releases and
1 disapproved release) that we examined to understand how SEC reviews
FINRA proposed rule changes and arrives at its decisions. We reviewed
the releases based on elements we identified from SEC's SRO rule
filing statute, including SEC allowing for public comments and
explaining its rationale for the decision to approve or disapprove a
proposed rule change.
To address our second objective, we reviewed OCIE documentation of
plans they have been developing for oversight of FINRA, and we
interviewed officials from OCIE about these plans. We also reviewed
documentation on OCIE's preliminary analysis of information collected
from FINRA on its regulatory programs and operations related to areas
identified in Section 964 of the Dodd-Frank Act, and the extent to
which OCIE's plans address these areas. We also reviewed other SEC
documentation on its plans for enhanced oversight, including risk
analysis plans for future inspections of FINRA, scoping memorandums
for areas of oversight identified in Section 964 of the Dodd-Frank
Act, and information and data requests SEC sent to FINRA regarding
these areas. We also reviewed SEC documentation on the implementation
of SEC organizational reform recommendations identified in a study
conducted by the Boston Consulting Group of SEC's structure and
operations. To assess SEC's risk-based oversight framework, we
reviewed literature and documentation on the Committee of Sponsoring
Organizations of the Treadway Commission's enterprise management
framework. We also reviewed guidance and documentation on the elements
of risk-management frameworks and prior GAO work on models or
frameworks related to agency oversight efforts.
We conducted our work from August 2011 through May 2012 in accordance
with generally accepted government auditing standards. Those standards
require that we plan and perform the audit to obtain sufficient,
appropriate evidence to provide a reasonable basis for our findings
and conclusions based on our audit objectives. We believe that the
evidence obtained provides a reasonable basis for our findings and
conclusions based on our audit objectives.
[End of section]
Appendix II: Comments from the Securities and Exchange Commission:
United States:
Securities and Exchange Commission:
Division of Trading And Markets
Office of Compliance: Inspections and Examinations:
Washington, D.C. 20549:
May 22, 2012:
A. Nicole Clowers:
Director:
Financial Markets and Community Investment:
U.S. Government Accountability Office:
441 G Street, NW:
Washington, DC 20548:
Dear Ms. Clowers:
Thank you for the opportunity to review the Government Accountability
Office's (GAO) draft report concerning the SEC's Oversight of the
Financial Industry Regulatory Authority. The SEC staff is separately
providing you with technical comments on the draft report.
GAO prepared the draft report in response to Section 964 of the Dodd-
Frank Wall Street Reform and Consumer Protection Act, which requires
GAO to review the Commission's oversight of FINRA in a number of
substantive areas. As you know, the Financial Industry Regulatory
Authority (F1NRA) plays a critical role in monitoring and regulating
activities in the securities industry. The SEC, in turn, operates a
robust program for the oversight of FINRA. Specifically,
as noted in the draft report, the SEC's oversight of FINRA is
primarily conducted by the Office of Compliance Inspections and
Examinations (OCIE) through its risk-based inspection and examination
process and the Division of Trading and Markets (DTM) through its
review of FINRA proposed rule changes.
As we discussed during GAO's review, OCIE conducted a critical self-
assessment of its inspection and examination process, adopting a risk-
based methodology, including developing a new risk-based approach for
FINRA. Since 2010, OCIE has enhanced and expanded its oversight of
FINRA. As part of this enhanced FINRA oversight, OCIE analyzed
extensive information from FINRA and conducted numerous interviews of
senior management, key personnel and members of FINRA's Board of
Governors regarding numerous areas, including areas not articulated in
Dodd-Frank Section 964.
GAO makes two recommendations in the draft report regarding the SEC's
oversight of FINRA. First, the draft report recommends that the SEC
encourage FINRA to conduct retrospective reviews of its rules as well
as establish a process for examining FINRA's reviews of its rules.
With respect to this recommendation, the Chairman has requested that
OCIE and DTM encourage FINRA to consider additional methods to conduct
retrospective reviews of its rules to assess whether FINRA's rules are
achieving their intended purpose. In addition, the Chairman
has requested that OCIE consider the most effective method to examine
or monitor FINRA's review of its rules.
Second, the GAO's draft report recommends that OCIE consider all
elements of a risk-management framework when developing future FINRA
oversight plans. These elements include: 1) identifying goals and
objectives for enhancing oversight of FINRA; 2) assessing FINRA's
potential risks; 3) considering alternatives for reducing risks; 4)
selecting the appropriate alternatives for enhanced oversight; and 5)
implementing and monitoring our risk-based oversight.
We appreciate that GAO acknowledged that since 2010 OCIE has
effectively implemented the first two critical elements of the GAO's
risk-management framework for enhanced FINRA oversight. While noting
that OCIE is still finalizing its enhanced risk-based oversight of
FINRA, GAO's draft report recommends that OCIE incorporate the
remaining three elements of a risk-management framework. We had
planned to do so, and agree with the GAO recommendation that the
implementation of the remaining elements of a risk-management
framework may better position OCIE to take a more comprehensive, risk-
based approach in overseeing FINRA. In this regard, OCIE will consider
how best to prioritize evolving and varying risks at FINRA, including
those not articulated in Dodd-Frank Section 964. OCIE also will
consider how best to evaluate alternatives and monitor our oversight
efforts. We anticipate that as we conclude our current review of FINRA
later in 2012, we will work to implement effectively the remaining
three elements of a risk-management framework described in the draft
report.
We appreciate the GAO's attention to these important issues and would
like to thank you and your staff for the opportunity to review the
GAO's draft report.
Sincerely,
Signed by:
Carlo di Florio:
Director:
OCIE:
Signed by:
Robert W. Cook:
Director:
Division of Trading and Markets:
[End of section]
Appendix III: GAO Contact and Staff Acknowledgments:
GAO Contact:
A. Nicole Clowers, (202) 512-8678 or clowersa@gao.gov:
Staff Acknowledgments:
In addition to the contact named above, Andrew Pauline (Assistant
Director), Vida Awumey, Chir-Jen Huang, Jonathan Kucskar, Tarek
Mahmassani, Marc Molino, Luann Moy, Jessica Sandler, and Jennifer
Schwartz made key contributions to this report.
[End of section]
Footnotes:
[1] SEC approved the establishment of the Financial Industry
Regulatory Authority (FINRA) in July 2007. FINRA is the result of the
consolidation of the former National Association of Securities
Dealers, Inc. (NASD) (which regulated the over-the-counter market for
exchange-listed and nonexchange-listed securities and provided
regulatory services to markets such as the American Stock Exchange and
the NASDAQ Stock Market) and the member regulation, enforcement, and
arbitration operations of NYSE Regulation, Inc.
[2] Pub. L. No. 111-203, § 964(a),124 Stat. 1376, 1910 (2010).
[3] This includes OCIE examination staff in headquarters and regional
offices.
[4] In addition to FINRA, SEC oversees more than 20 other SROs,
including national stock exchanges, such as the New York Stock
Exchange, NASDAQ, and Chicago Options Board Exchange, registered
clearing agencies, and the Municipal Securities Rulemaking Board.
[5] Securities Exchange Act of 1934, Pub. L. No. 73-291, 48 Stat. 881
(codified at 15 U.S.C. § 78a et seq.).
[6] Certain proposed rule changes designated by an SRO pursuant to
Section 19(b)(3)(A) of the Exchange Act become effective upon filing
and do not require approval by SEC before they go into effect. SEC may
suspend the proposed rule change within 60 days of the filing date if
it appears to SEC that such action is necessary or appropriate in the
public interest, for protection of investors, or in furtherance of the
purposes of the Exchange Act. If SEC takes such action, it must
institute proceedings to determine whether to approve or disapprove
the proposed rule. 15 U.S.C. § 78(b)(3).
[7] The proposed rule change must contain a general statement of its
basis and purpose.
[8] SEC must send notice of the proposed rule change to the Federal
Register within 15 days of the SRO's website publication date. 15
U.S.C. § 78s(b)(2)(E). The SRO must publish the proposed rule change
on its website within 2 business days of filing with the SEC. 17
C.F.R. § 240.19b-4(l).
[9] The Division of Trading and Markets helps SEC maintain fair,
orderly, and efficient markets by providing day-to-day oversight of
the major securities market participants, such as the securities
exchanges, securities firms, and SROs. Its responsibilities include,
among others, reviewing proposed new rules and proposed changes to
existing rules filed by SROs, assisting SEC in establishing rules and
issuing interpretations on matters affecting the operation of the
securities markets, and conducting market surveillance.
[10] Prior to the Dodd-Frank Act, SEC could either approve a rule upon
an initial review or institute proceedings to determine whether a
proposed rule should be disapproved.
[11] The proceedings include SEC providing notice and opportunity for
a hearing to consider the potential grounds for approval or
disapproval, after which SEC makes a final decision by issuing an
approval or disapproval order. The Dodd-Frank Act also amended the
Exchange Act to extend the period in which SEC must approve or
disapprove a proposed rule change or institute disapproval proceedings
from 35 to 45 days. However, SEC may extend the period by an
additional 45 days if it publishes the reasons for a determination
that a longer period is appropriate or the SRO consents to the longer
period. Pub. L. No. 111-203, § 916(a) (codified at 15 U.S.C.
§78s(b)(2)(A)).
[12] SEC must issue an approval or disapproval order within 180 days
of the publication date. However, SEC may extend the period by an
additional 60 days if it publishes the reasons for a determination
that a longer period is appropriate or the SRO consents to the longer
period. If this extension occurs, then SEC has 240 days from the
publication date to issue an approval or disapproval order.
[13] Routine inspections are planned inspections for aspects of FINRA
but they vary in the frequency with which they are scheduled to be
conducted. According to SEC, numerous factors such as commission
priorities, risk analysis, and previous inspections play a role in
determining the frequency of the inspections.
[14] There are 11 FINRA districts with 15 offices, including Atlanta,
Boca Raton, Boston, Chicago, Dallas, Denver, Kansas City, Long Island,
Los Angeles, New Jersey, New Orleans, New York, Philadelphia, San
Francisco, and Seattle. FINRA's Long Island office, located in
Jericho, New York, is a satellite office of FINRA's New York district
office. The inspections of FINRA's New York district office included a
review of the Long Island office.
[15] The 16 FINRA regulatory programs in the district office
inspections included routine or cycle examinations; formal
disciplinary actions; the prior national exam program surveillance
system; statutorily disqualified persons and member firms; branch
office examinations; business gifts, gratuities, and courtesies;
financial surveillance; employee securities accounts; subordination
loan agreements; membership program; clearing agreements; advertising;
new member examinations; automated customer account transfer system;
cause examinations; and compliance with municipal rules.
[16] FINRA's cycle examinations are designed to determine whether
member firms are in compliance with various SEC, FINRA, and Municipal
Securities Rulemaking Board rules and regulations.
[17] OCIE also previously assessed the quality of FINRA examinations
of broker-dealers through its own examinations of broker-dealers that
FINRA examined. Although these examinations served as an oversight
function, we previously found that they expose firms to duplicative
examinations and costs. See GAO, Mutual Fund Industry: SEC's Revised
Examination Approach Offers Potential Benefits, but Significant
Oversight Challenges Remain, [hyperlink,
http://www.gao.gov/products/GAO-05-415] (Washington, D.C.: Aug. 17,
2005). As a result, OCIE stopped conducting these inspections in 2011.
[18] GAO, Securities and Exchange Commission: Opportunities Exist to
Improve Oversight of Self-Regulatory Organizations, [hyperlink,
http://www.gao.gov/products/GAO-08-33] (Washington, D.C.: Nov. 15,
2007).
[19] FINRA's advertising regulation program is also referred to as the
customer communication program in SEC documentation.
[20] For more information on mutual fund advertising and how the
regulatory requirements are administered and enforced, see GAO, Mutual
Fund Advertising: Improving How Regulators Communicate New Rule
Interpretations to Industry Would Further Protect Investors,
[hyperlink, http://www.gao.gov/products/GAO-11-697] (Washington, D.C.:
July 26, 2011).
[21] OCIE is reviewing FINRA's fixed-income regulatory program,
focusing on the effectiveness of FINRA's surveillances in the markups
area and also reviewing trade reporting in corporate and municipal
fixed-income instruments.
[22] Based on a joint report issued by the Commodity Futures Trading
Commission and SEC, on May 6, 2010, the prices of many U.S.-based
equity products experienced an extraordinarily rapid decline and
recovery. That afternoon, major equity indices in both the futures and
securities markets, each already down over 4 percent from their prior-
day close, suddenly plummeted a further 5 to 6 percent in a matter of
minutes before rebounding almost as quickly. High frequency trading is
a subset of algorithmic trading where the high speed with which
individuals detect and act on profitable trading opportunities in the
marketplace is the defining characteristic. Algorithmic trading is the
use of computer and advanced mathematical models to make decisions
about the timing, price, and quantity of the market order.
[23] For example, form 19b-4 requires FINRA to indicate whether the
proposed rule change is an initial filing or an amendment to an
existing rule as well as whether the proposed rule change is being
filed for approval under Section 19(b)(2) or for immediate
effectiveness under Sections 19(b)(3)(A) or 19(b)(3)(B).
[24] A complete filing is one that complies with all of the form 19b-4
requirements, the guidelines for publication in the Federal Register,
and any requirements for electronic filing as published by SEC (if
applicable).
[25] For some proposed rule changes that are subject to SEC approval,
SEC can grant approval on an accelerated basis if it finds good cause
to do so and publishes the reason for the finding.
[26] SEC releases include rule orders describing SEC's final decision
regarding FINRA proposed rule changes and notices.
[27] We selected for review 19 SEC releases. Specifically, we randomly
selected 2 releases for each year from 2009 through 2011, for a total
of 18 releases, from the following categories: releases approving
proposed rule changes, releases granting accelerated approval of
proposed rule changes, and releases notifying the public of
immediately effective proposed rule changes. In addition, we reviewed
1 release disapproving a proposed rule change, the only one for the
time period reviewed. For more information on our methodology, please
see appendix I.
[28] FINRA posts all of its proposed rule filings on its website
within 2 business days of filing with SEC.
[29] Trading and Markets and OCIE conducted an outreach conference in
January 2012 to provide information and clarification about the rule-
filing process, OCIE's oversight and inspections of SROs, and other
similar areas to the SROs SEC oversees.
[30] Independent regulatory agencies are those defined by 44 U.S.C. §
3502(5).
[31] GAO, Reexamining Regulations: Opportunities Exist to Improve
Effectiveness and Transparency of Retrospective Reviews, [hyperlink,
http://www.gao.gov/products/GAO-07-791] (Washington, D.C.: July 16,
2007)
[32] Section 610 of the Regulatory Flexibility Act requires
independent and other regulatory agencies to review within 10 years of
publication any of their rules that have a significant economic impact
on a substantial number of small entities. Pub. L. No. 96-354, §3(a),
94 Stat. 1164, 1169 (1980) (codified at 5 U.S.C. § 610).
[33] FINRA is an SRO, incorporated in Delaware as a nonprofit entity,
and is therefore not an independent regulatory agency.
[34] FINRA's governance structure is outlined in its by-laws, which
among several qualifications include diverse industry representation
of three small, one medium, and three large firms. In 2006, OCIE
conducted a special inspection of the NASD Board of Governors election
based on a complaint. In its review, OCIE found that NASD generally
conducted its election in accordance with its legal obligations and
did not find any deficiencies that its staff believe would have
changed the outcome of the election.
[35] [hyperlink, http://www.gao.gov/products/GAO-08-33].
[36] FINRA's internal audit department uses a risk-based approach in
developing its plan for audits of FINRA regulatory programs and
operations over a 4-year cycle. The approach includes annual risk
assessments that assess various types of risks, such as financial and
regulatory risks, and the internal controls related to FINRA programs
and operations.
[37] FINRA's Board is comprised of governors representing various
groups and interests, such as small, mid-size, and large firms;
investment companies; and the public.
[387] Since 2004, FINRA has retained the services of a consultant to
conduct a review each year to provide the Management Compensation
Committee with ongoing guidance concerning competitive executive
compensation pay levels, overall compensation program structure, and
other related compensation matters.
[39] COSO was organized in 1985 to sponsor the National Commission on
Fraudulent Financial Reporting, an independent private-sector
initiative that studied the causal factors that can lead to fraudulent
financial reporting. It also developed recommendations for public
companies and their independent auditors, for SEC and other
regulators, and for educational institutions, including frameworks and
guidance on enterprise risk management.
[40] GAO, Risk Management: Further Refinements Needed to Assess Risks
and Prioritize Protective Measures at Ports and Other Critical
Infrastructure, [hyperlink, http://www.gao.gov/products/GAO-06-91]
(Washington, D.C.: Dec. 15, 2005).
[41] [hyperlink, http://www.gao.gov/products/GAO-08-33].
[42] SEC releases include rule orders describing SEC's final decision
regarding FINRA proposed rule changes and notices.
[End of section]
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